Insights into Editorial: Time for a brand new FRBM Act

Since its introduction, the Fiscal Responsibility and Budget Management Act has been facing a rocky road in terms of implementation.

Paused four times since its enactment in August 2003, including for a reset of the fiscal deficit target in 2008-09 following the global financial crisis, the FRBM Act has become a subject of animated debate.

Central to this has been the question of whether the law has served the purposes for which it was envisaged. There is no denying that the Act has helped focus attention on the issues relating to fiscal consolidation. But with regard to the larger objective of ensuring macro-economic stability, the record has been less than ideal.

Besides, the FRBM Act, 2003, has many flaws and we need to reflect on five issues and produce a truly modern act-

Are fiscal rules really helpful?

They are neither necessary nor sufficient to ensure good behaviour, but they can be potentially helpful. India’s experience bears out this assessment. The FRBM Act succeeded in disciplining the states, because the states cannot borrow without the permission of the centre, but it was spectacularly ineffective in disciplining the centre. The act failed to reduce centre’s deficit.

Besides, experts argue, such acts are ineffective where Parliament doesn’t function as an effective watchdog.

This act can be effective in a presidential system but not in a parliamentary system, where the government can have its way because it commands a majority in the legislature.

What can be done?

Well-designed fiscal rules can at least help encourage a spirited discussion in Parliament on the consequences of departing from the rules and could have an impact on public opinion and market expectations.

What is a reasonable fiscal deficit?

The existing FRBM Act prescribes a target fiscal deficit of 3% of GDP for the centre but with no explicit justification for the number. Since there is also a separate limit for the states (although not specified in the Act), the combined fiscal deficit (general government deficit in International Monetary Fund terminology) is much larger.

The Fourteenth Finance Commission (chaired by Y.V. Reddy), for example, has explicitly recommended a 3% fiscal deficit for the centre and another 3% for the states, yielding a combined limit of 6% per year for the period 2015-16 to 2019-20.

Ideally, the FRBM Act should not prescribe specific numbers. Instead it should require the government to present every year an explicit analysis of the crowding-out implications and government debt-to-GDP ratio implications of the proposed fiscal deficit trajectory of the combined deficit over the next five years based on explicit assumptions about GDP growth, household savings and inflation.

This would bring out more clearly the rationale for the target and would guide discussions of departures.

Apportioning the total deficit between the centre and states:

The total deficit has to be divided between the centre and the states. Since the states have been given a large increase in their share of the centre’s tax revenues, it is reasonable to divide the total combined deficit of, say, 4% of GDP into 3% for the centre and 1% for the states. A higher allocation for the states implies a lower allocation for the centre. The proposed division and its rationale should be reported to Parliament under the FRBM Act.

Besides, the 1% limit for the states as a whole also has to be converted into entitlements for individual states. Past practice would allow each state to borrow up to 1% of its gross state domestic product (GSDP). This seems fair, but it can be argued that states with high debt ratios should borrow less and states with a low growth potential should also borrow less. This may seem unfair, but financially weak states should be helped with more grant funds and not more borrowings.

Should fiscal targets be flexible?

The most important reason for flexibility is the need to deal with cyclical shocks. The fiscal deficit in the budget is the gap between explicit expenditure and revenue projections, which, in turn, are based on reasonable expectations regarding growth of GDP. If for some reason there is a temporary shock, such as a fall in export demand, or a temporary choking of investment, or poor rains, revenues could turn out to be lower than expected. Expenditures could also be higher for cyclical reasons, for example a drought leading to higher expenditures under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA). These could increase the fiscal deficit in absolute terms, and if GDP is also lowered, the deficit as a percentage of GDP would be even higher.

In a cyclical downturn, it doesn’t make sense to adhere to the earlier deficit target by cutting expenditures or raising taxes. Instead, we should allow the deficit to exceed the target as a contra-cyclical measure. However, it should not be an open-ended departure from the target, but one which ensures that the “structurally adjusted” deficit remains on track.

The structurally adjusted deficit is what the deficit would have been if the cyclical shocks had not occurred. And the approach must be symmetric—when positive shocks produce an unexpected gain in revenue, the observed fiscal deficit should be lower than the target.

Would a Fiscal Accountability Council help?

Both the Thirteenth Finance Commission and the Fourteenth Finance Commission recommended the establishment of an autonomous body to review fiscal performance under the FRBM Act. This could evolve into a statutory Fiscal Council, reporting to Parliament through the finance ministry. Such institutions have been set up in several countries, with somewhat varying mandates.

A Fiscal Council, with technical expertise, would help generate better understanding of the consistency of fiscal stance of each budget with the longer-term fiscal trajectory envisaged under the FRBM Act. It would certainly improve the quality of Parliamentary oversight and also contribute to a more informed public debate.

The Council would also strengthen the hands of the finance ministry, which is otherwise the lone guardian of fiscal prudence, battling other ministries typically keen on expanding expenditure.

Conclusion:

It is in this context that the finance minister, in his budget speech, announced that a committee would be set up to review the implementation of the Fiscal Responsibility and Budget Management Act (FRBM Act) and suggest modifications for the future. A major restructuring of the FRBM Act, taking account of these considerations, would produce a truly modern legislation in this important area.